But My Amp Goes to 11! The Spinal Tap Approach to Government Loan Accounting

May 29th, 2013 at 3:45 pm

There’s a very wonky dust-up afoot about how the federal government accounts for its lending programs, like student loans. The resolution is important, since if we were to make the change for which some influential folks are calling, our budgets would reflect considerably higher costs for government loans.

Now, mind you: no one—including opponents of the current way we score our loan programs—is arguing that those programs would actually cost the government any more than they do now. Those calling for the change want the budget to reflect higher costs, even though they don’t believe the government will actually face those costs. As I argue below, that makes them phantom costs.

To understand why some are calling for changing from the current method to the so-called “fair-value accounting” (FVA) method, you have to understand how these loans are currently treated in the budget. When the government makes a loan, the cash dispersed to the borrower is considered government spending. But because we expect most borrowers to repay, the budget subtracts the value of what it expects to get back. That subtracted value is reduced to account for the fact that some borrowers will default or pay late and also to account for the estimated value today of interest payments and principal expected to come back to the government over the course of the loan (the “net present value”).

So far, so good. FVA’ers don’t disagree with this part of the deal. But they argue that there’s another cost which we’re leaving out of the picture: the extra costs that would be invoked if a private lender were making the loan.

You see, private lenders face various disadvantages relative to the government and they reasonably want to be compensated for them, so they charge more for their loans. They can’t borrow as cheaply as Uncle Sam, they can’t tax, they can’t print money, they won’t make loans unless they expect to make a profit on them, and for all these reasons, they’re more risk averse. So they add a risk-premium to their interest rate.

The FVAers believe that the government should treat its loans (and loan guarantees) the same way that private lenders treat them, essentially adding the cost of the “market risk” faced by private lenders on top of the present value cost already in the budget.

To folks on the other side of the argument, like me and my CBPP colleagues, this makes no sense. The government as a lender differs in fundamental ways from its private counterparts, and those differences must be reflected in the budget. That doesn’t imply riskless lending. As noted, the full likelihood of defaults or late payments and the probability of changes in interest rates need to be taken account of – as they already are. But to charge the government for market risks it does not face is to create phantom costs, (which in turn, invoke the need for phantom offsets).

Here’s an important wrinkle that I think shows the folly of the suggested change.

The FVAers don’t want the government to actually charge a risk premium to say, student borrowers. They just want us to record the budget costs as if the government had to charge a risk premium but failed to do so. They want government lenders to take advantage of their special characteristics noted above and lend at favorable rates relative to private lenders. But they want us to write down the value of our loan portfolio if we were private lenders.

Why? I’m not 100% sure. The FVAers seem to think the current accounting methods give the government an unfair advantage over private lenders, and want to put them on equal footing. They seem put out, for example, by the fact that our student loan program is scoring as a “negative subsidy”—it’s making money—right now, as the government is taking advantage of favorable spreads between its borrowing and lending costs.

Perhaps the FVAers want to artificially pump up the budgetary costs of the loans because they worry that a government that can lend more cheaply than the private sector will fail to impose enough discipline on its lending programs. While I’m obviously opposed to the shift to FVA, that’s not an unreasonable concern. I don’t want to see the government take advantage of its unique ability to lend at lower costs than private lenders such that it gets into all kinds of different markets. Student loans are different, since they support an important public good. But if this is the FVAer’s motivation, I kinda see where they’re coming from.

It’s just that their solution to the problem is flat-out wrong. Government ≠ private sector—and pretending that inequality doesn’t hold is just plain distortionary.

In this regard, the FVAers seem a bit like Nigel from the band Spinal Tap describing how his amplifier is extra loud because it goes up to 11 instead of 10. To most of us, the fact that someone drew an “11” on a dial that used to read “10” doesn’t change the amp’s maximum volume.

The budget scores loans at a “10” because a “10” is the best estimate of the cash flows, just as the amp recorded its highest volume at 10 before someone changed the dial’s top value to read “11.” The FVAers want us to record an “11” or “12” or whatever because that’s how that’s how (heavily medicated) Nigel perceives volume much like they say the public perceives risk. But the noise that the amp makes at 10 is the same it makes at 11.

Or try this one: if it’s good budgeting to add in the higher cost of private sector risk aversion, uncertainty, and so on to lending programs, then mustn’t we value and add the benefits of reduced uncertainty which our social insurance and safety net programs afford us? As it stands, the future costs of these programs are based on our best guesses about what it will cost to provide the income (e.g., Social Security) and health benefits (Medicare) to those entitled to such benefits. But those projections, especially re medical costs, invoke considerable uncertainty—uncertainty which is borne by the government, not by the beneficiaries. The logic of the FVAers would have us tote up the value of this risk shift from retirees to the government and subtract it from the budgetary costs.

That might help make our budget projections look better but it would be as unjustified as what they’re proposing re the lending programs. So let’s leave things as they are here and not bend ourselves into a budgetary pretzel in order to pretend the government isn’t the government. Even if our amp goes up to 11.

21 comments in reply to "But My Amp Goes to 11! The Spinal Tap Approach to Government Loan Accounting"

1. So how much does the “cost” get reduced because student loans can’t be discharged in bankruptcy whereas nearly all other loans can?

2. How much does the “cost” get reduced because the proportion of expenses picked up by grants gets reduced and picked up instead by kids mortgaging their futures?

3. With the 90% “tipping point” now shown to be a fantasy created by debt hawks to help their political funders, what’s the objective of this new fantasy (other than to fill the airwaves and displace serious discussions of real pressing problems)?

Using the accounting rules that you support (not fair value) a U.S. government purchase of all of Greece’s debt would show a large profit immediately. Does that sound right? It is what you are saying in much fewer words. The government can buy up any bond in the market and make a profit.

Fair value and the rules you support use the EXACT same estimates of defaults. The official rules already include expected defaults, they are already adjusted, and in fact do show a purchase of any risky bond as an immediate profit for the government, including those of Greece.

Here is the Congressional Budget Office: “FCRA and market-based cost estimates alike take into
account expected losses from defaults by borrowers.”

Again, from the CBO: Under the official accounting rules “purchases of loans at market prices appear to make money for the government.”

There’s not really an easy, simple answer to this complex problem and, while the CBO paper you cite makes a laudable stab at such an answer, it includes a lot of different “stuff” in a category it refers to as “market risk.” (most finance texts spend several chapters explaining the differing approaches to assessing the impacts of these various “market risks.”) My take from Jared’s post is that there is no reason to believe that the basket of “risks” that the government faces is close enough to those faced by other lenders that using their estimates would a provide a better estimate of the values of (or costs associated with providing these) loans than the current methods; and certainly they shouldn’t just be added to the costs as this would almost certainly overstate the costs even in the event the government faced similar risks. Obviously all lenders face the risks that inflation will be higher (or lower) than their projections; that defaults will be higher (or lower) than their projections; that administrative and collection costs (and fees) will be higher (or lower) than their projections. the timing of cash flows will be higher (or lower) than their projections, that the cost of funds can be higher (or lower) than projected, and that the costs of hedging against mismatched durations can be higher (or lower) than projected. As it turns out, the government has abilities to control these risks that are not available to private lenders. Assuming they’re the same just leads to erroneous conclusions – garbage in – garbage out.

In addition to risks the government also faces, private lenders face other risks, pressures, and costs that don’t affect government lending i.e. profits, taxes, finite resources, higher profit opportunities (or lack of) that effect how much margin they can add to these loans, CEO and other executive compensation, etc.

I can’t really see a reason why a government or a bank or any other large lender (other than one on the verger of insolvency) would be anymore risk averse in assessing expected values than a casino or an insurance company on this and think the whole risk aversion argument just adds an unnecessary level of complexity here, but is it possible the government has erred systematically downward in its projections? Sure it is. Is the way to correct for that by assuming it looks like a bank or other lender from a cost standpoint and just pile some fictitious costs on top of the original projections a reasonable way to “insure” against the possibility that they have? Hardly seems like a persuasive argument to me; and I don’t see that the Greek debt argument changes (or even enters in to) any of it. Is there a proposal afoot that the government should use its substantial advantages to speculate in Greek debt?

You wrote: “My take from Jared’s post is that there is no reason to believe that the basket of “risks” that the government faces is close enough to those faced by other lenders that using their estimates would a provide a better estimate of the values”

The fact that the government may theoretically face a different “basket of risks” from the private sector does not mean that the risks can be discounted essentially to zero (by not accounting for them). Default (however remote) is always a risk, and the fact that the government can mitigate this risk by borrowing more, taxing more, or printing more does not eliminate that risk, because each of these “solutions” is a cost in and of itself.

This is akin to states and municipalities funding their pension programs: historically, rating agencies basically discounted the risk of government failing to meet its obligations precisely because it could tax and borrow to its heart’s content, or roll over debt to future generations. However, as the spate of recent municipal bankruptcies and state-takeovers of cities (Camden, Detroit) show, this “basket of risks” cannot be zeroed out in such a cavalier manner.

Here are two official estimates that illustrate how the government can in fact buy up any risky debt and appear to make a profit, after factoring in expected defaults.

In 2009, the CBO estimated the effects of the government buying up private student loans, this was when risk premiums were at their peak during the financial crisis. In other words, they were even more risky than Greek debt, with higher interest rates.

The proposal would generate an immediate profit of $9.155 billion, AFTER estimating for expected defaults, using the official accounting rules.

$9 billion profit to buy up private student loans. Why stop there, right? Imagine how big the profit would be from buying up Greek and Spanish debt. And remember, according to the official accounting rules (which you defend here) the riskier the loans, the bigger the immediate profit for the government.

October 2008, amidst financial chaos and imminent financial collapse of many financial institutions, the government made loans to investment banks at 4% interest — the going rate in the market was 12% (See Warren Buffet’s loans to Goldman Sachs). What did the official accounting rules show for such a massive subsidy and big risk in 2008? An immediate profit of $12.6 billion. http://www.whitehouse.gov/sites/default/files/omb/assets/omb/legislative/eesa_120508.pdf

These are the results of the rules you are defending. Do you agree that they are correct? That the government should book and immediate profit for buying up risky debt, and the profit should increase with the degree of risk?

Yes, I do believe the USG would make money on such loans as you deride. In fact, we have done precisely that with the TARP! But your argument here does help me understand where you’re coming from and underneath our disagreement, there’s a fundamental agreement as well.

All you’re saying is that if the present value of the expected cash flow from a debt buy—any debt buy–discounted at US Treasury rates, is positive, then I want the budget to score it as such. That’s true and I agree–the fact that it’s troubled Greek debt doesn’t change that. Again, you must assume here that default, late payment, interest rate risks are fully accounted for in the NPV calculations.

You also must assume there’s a risk premium that any investor in risky (e.g., Greek) debt, public or private, would earn. The difference is that the unique attributes of the USG (articulated in my post and, I think, agreed to by FVAers) allow it to more efficiently bear risk than private actors.

So, getting back to the heart of my post, FVAers would like the budget to value the USGs portfolio of assets and liabilities the same way the markets value them, when they are in reality worth more to us – they are worth the cash they actually return, not some lower amount that accounts for private sector risk/loss aversion.

TARP debt and Greek debt may be a lot uglier than say, student debt, but that doesn’t mean that the USG would lose money on them—as pointed out, that demonstrably wasn’t the case with the TARP banks. Gov’t is not the private sector—for all the reasons I laid out—and if we try to add some non-budgetary cost to a budgetary cost, we’d get a number that is both misleading and not meaningful.

So why would you want to do it? Here’s where we may agree. I get the feeling it really bothers you that the gov’t can make money on weird deals like this. Perhaps you worry it will lead short-sighted pols to buy Greek debt or Buddha-knows-what else. So you want to cook the books to make the deals look worse than they really are.

I worry about that too. The fact that the USG is a unique and privileged lender relative to the private sector doesn’t mean it should raise money that way anymore than it should raise money by cutting the safety net or social insurance. Our discourse has led me to wonder if FVAers simply want to impose more discipline on gov’t lending (a good idea) but are proposing to do so through squirrely budgeting (a bad idea).

Anyway, this (comments) is no place to hash this out—though important, it’s pretty obscure and we risk losing our readers, if not invoking Krugman/Rogoff arguments (with me as PK, of course)…perhaps there’s a different venue to continue the argument.

Jason, you are championing using private loan interest rates to calculate losses to the federal student loan program. How is the private loan market (which is hugely dependent/distorted by the federal market) a meaningful benchmark? How is it in any way appropriate?

By your rationale: Why doesn’t Exxon point to the biodiesel enthusiasts selling their gas for $8/gallon, and use this to justify writing off $4 (or more) for every gallon it sells?

This is the fourth time, at least, that I have put these questions to you, Jason, and never have you ever responded. I think you’d do well to at long last answer these questions.

Why do you continue to continue to completely ignore years of historical recovery rate data which shows, consistently, that the government recovers $1.22 for every dollar it pays out (A bit less for Direct Loans)? Even assuming for the moment that your choice of benchmark (private loans) is valid, and assuming very large collection and other costs), we are still left with the government making a profit on FFEL loans -more than if the loan had never defaulted. Mark Kantrowitz has acknowledged this is true, even…yet you refuse to debate the issue.

When I contacted you years ago proposing that we get to the bottom of this question of government profiteering on defaults in a good faith, reasoned manner, you seemed to agree to the proposal, but then rushed out a piece the next week with the headline declaring “Government doesn’t profit on defaults”. Since then, you’ve repeated this assertion numerous times, but failed to support your position.

You wrote: “Why do you continue to continue to completely ignore years of historical recovery rate data which shows, consistently, that the government recovers $1.22 for every dollar it pays out”

Most lenders recover more than each dollar they lend out, otherwise they would go bankrupt. The question is not whether there is a net gain; the question is whether this net gain properly reflects a “profit” vis-a-vis the alternative uses that dollar could have been put.

In other words, does that extra 22 cents properly compensate for the time value of money? Does it properly represent the opportunity cost of not using that same dollar for other government spending? You can’t just look at “profit” and say everything is hunky-dory.

“Why do you continue to continue to completely ignore years of historical recovery rate data which shows, consistently, that the government recovers $1.22 for every dollar it pays out (A bit less for Direct Loans)? Even assuming for the moment that your choice of benchmark (private loans) is valid, and assuming very large collection and other costs), we are still left with the government making a profit on FFEL loans -more than if the loan had never defaulted. Mark Kantrowitz has acknowledged this is true, even…yet you refuse to debate the issue.”

Keep pushing the issue. If historically this is not occurring, than why assume it now? Furthermore the CBO is not as Bi or non partisan as some would hope. Elmendorf assisted putting the final nail in Hillarycare in 93. Most recently he sent a private email to Yves at Naked Capitalism looking for a private conversation concerning the Sheiner and LaFollette study on Healthcare costs.

Going in a different direction, does the whole student loan industry not simply feed the inflation of college costs? When students become “customers” hasn’t the emphasis changed in a way that is very costly on a good many levels?

Yes, I realize this is off point and anything that makes the student loan program less predatory is good it seems the loan programs actually feed something of a monster.

Government has advantages in other areas, too. The sheer size of the Medicare program give the government much larger negotiating leverage with providers than private insurers can command. Further, the economies of scale make administrative costs very low.

But to me, this is reason to prefer government-run health insurance. If you can get the same (or better) product for lower cost, why the heck wouldn’t you do that?

I think this whole “private=good, government=bad” outlook is ridiculous. Instead of trying to privatize everything, we should be looking at ways to make government work better. There are plenty of opportunities to do so.

As an accountant, this sort of debate about accounting practices frustrates me. It doesn’t make any sense to record costs on government books based on advantages it has over the private sector, especially when it doesn’t reflect any actual costs facing the government.

Accounting is supposed to reflect reality, but so many accounting practices (especially those related to “fair value” or “market value”) actually serve to manipulate and/or distort the underlying economic reality and make good decision-making harder to accomplish.

Jared is right. CBO’s “fair-value” method assumes that the federal government should be as is risk adverse as the private sector. But most economists would think that the federal government, by its ability to tax and its much larger portfolio, should be risk neutral. This imposed risk aversion is one reason why the CBO numbers are DESIGNED to provide an inaccurate estimate of the BUDGET costs of an activity. Indeed, using CBO methods, the expected present value cost of TARP was positive, but the expected effect on national debt was negative.

Well, perhaps I can take a stab at it. I’m not 100% sure, either, but I have my suspicions. Perhaps it might have something to do with the fact that “government is bad” and “the private sector is God”, so that any apparent advantage enjoyed by or extended by the government in any effort similar to private-sector efforts becomes Socialism!!!1!1 and must be done away with. If it can’t be done away with, it must be made punitive, because only harsh lessons to the lazy, undeserving poor can make them morally strong. Student loans must be made fair in the same way that sleeping under a bridge becomes equally illegal to rich and poor alike. Now, I’m not 100% sure that’s the reason for this proposal; perhaps it’s a high-minded concern for the souls of some group or other, or perhaps simple confusion on the part of some lawmakers. Still, even though I don’t shave, I still have Occam’s old razor lying around, and I try to use it from time to time for old times’ sake.

While your comment is completely unrelated to my initial question to Jason, which he still has yet to answer, this is a secondary issue worth responding to.

Philip: You point out: “Most lenders recover more than each dollar they lend out, otherwise they would go bankrupt.” I agree. This is tautological.

But we are discussing DEFAULTED loans, here. DEFAULTED loans, in any other lending system, are ALWAYS a loss. Credit Card companies, for example, are thrilled to recover $.15 cents on the dollar for their defaults. I really don’t know why you chose to insert this comment, but let’s not be distracted by it beyond this,shall we?

The real point that you seem to want to make is that there is an opportunity cost associated with a dollar that is tied up in recovering the defaulted loan, and that this cost may well eat into the 22 cents in “profit” to the point where it is a loss. This may be true were the lender a private bank, with finite access to wealth, but for the government this is absolutely an untrue statement. There is no student that goes without a loan as a result of a defaulted loan. There is no other investment that goes unmade either. As long as the government is reasonably sure that this default will produce enough to cover itself, and the cost of it’s borrowing (T-Bill rates)- and it is in this case- then there really is no debate but that it is an investment worth making, if the bottom line is all that is important.

But that is not what is important about this issue. The CRITICAL, MEANINGFUL question, here, is whether a default under these conditions becomes a preferable outcome to the government then had the loan never defaulted. For the Case of FFELP Loans, it clearly, and obviously is. I describe this case sufficiently at http://www.studentloanjustice.org/defaults-making-money.html )

Therefore, it is really beyond reasonable debate that, at least for FFELP loans, the Government has a clear financial proclivity to want defaults. For Direct Loans, this is less clear, but without doubt, the first point remains that the government is making money on defaults.

Philip: If you realized that your home mortgage holder wanted you to default on your loan, do you think they’d do a great job administering it? Would you consider that a fair lending system? No. You would immediately cry foul, and everyone reading this would be compelled to agree that this was an unfair, untenable, indefensible, and intolerable arrangement.

If your lender made money whether you defaulted or not (even if it made more if the loan didn’t default), you would still have good grounds to claim foul, because it would still remove the strong incentive that a potential loss due to default provides which would ensure that the lender acted fairly so as to avoid a default.

We can pick opportunity costs out of the air all day long, each more fantastic than the one before, and create evermore outrageous, and false, claims. Soon, people like Jason Delisle will be pointing to Payday lenders, or stock in Apple Computers, or ANYTHING THEY WANT as a basis for claiming that student loans actually cost the government ANY AMOUNT DESIRED.

There is nothing real, honorable, or “Fair” with this method in the subtext of the current secondary issue of default profitability that we now are discussing, or for the larger issue that is the basis of my initial, and as yet unanswered question to Jason.